Friday, March 07, 2014

How macro answered its critics

I've spent a lot of time griping about modern macroeconomics, but I want to take a minute to point out how quickly and adroitly the profession (paradigm? research program? hive mind?) has responded to many of the major criticisms leveled at it since the 2008 financial crisis. Here are what I see as the attacks macro has more or less fended off:

1. "Macro didn't predict the crisis."

This one never really seemed to stick in the first place. First of all, precious few people predicted the crisis, and a number of those that did have tended to be the type of people who predict crises every week. In 2011, a lot of the people who supposedly got 2008 were predicting another crisis - a wave of government defaults, followed by hyperinflation. Didn't happen. Meanwhile, people remembered that there are things out there that are just really hard to predict, like earthquakes.

And also, it's not like macroeconomics betrayed the people's confidence in this regard. I don't think many people inside or outside of the profession thought in 2007 that macro was able to predict recessions, financial crises, etc.

(Note: There's also the criticism that before 2008, macro ignored the possibility of crises in general. That's a different issue. But anyway, see Criticism #2...)

2. "Macro doesn't include finance."

This was somewhat true for a very short time following the 2008 crisis. Why? Because it takes a few months to write papers and get them out there. It is true that before 2008, finance didn't get much attention in macro models. But instead of sticking their heads in the ground, top macroeconomists responded to the crisis by racing to make models in which the financial sector drives recessions. For example, in 2009, Michael Woodford and Vasco Curdia came out with "Credit frictions and optimal monetary policy", and in 2010, Larry Christiano and coauthors came out with "Financial factors in economic fluctuations". Those are two top macro guys, but early efforts like those were only the thin edge of a very large wedge. As of now, practically every macro paper I see, from top people, young entrants, and central bank economists includes "financial frictions", "financial shocks", "credit frictions", a banking sector, leverage restrictions, or something along those lines. Financial macro is absolutely the In Thing right now. And there has been increased interest, attention, and recognition directed toward economists who were thinking about the financial sector before 2008.

Basically, the speed with which macro has put finance at the center of its theories of the business cycle has been nothing less than stunning.

3. "Macro thinks the economy is a representative agent with rational expectations. Ha!"

The representative-agent thing had actually been challenged long before the crisis. Simpler macro models, like OLG-type models, often include multiple types of agents. There have been efforts to put heterogeneity into big DSGE-type models too - for example, the Krusell-Smith (1998) model (these didn't get quite as far, because this kind of thing is very technically difficult to model). Heterogeneity also exists in a number of the labor search type models that were getting popular even before the crisis. In most of the new financial-macro models, there are heterogeneous agents of various types - for example, creditworthy borrowers and bad borrowers, in models of bank lending. Of course, representative consumers and firms still dominate the literature, because they're simply a lot easier to use than the alternative. But they're not the only game in town; macroeconomists are definitely thinking about heterogeneity.

As for rational expectations, there have not been many attempts to replace rational agents with irrational ones (though some top theorists have played around with the idea). An alternative concept of rationality, Bayesian learning, has been getting more attention from DSGE theorists. But so far, macroeconomists are still very timid about abandoning this pillar of the Lucas/Prescott Revolution. Why? One big reason is that there's no clear alternative. There are lots and lots of ways people could be irrational, and it takes a big leap of faith to pick one of those ways and run with it. That's probably why critics of this aspect of macro are frustrated, and will continue to be frustrated - it's easy to see that rational expectations isn't a law of the Universe, but it's devilishly hard to agree on which alternative should replace it.

4. "Macro models are too big and clunky to be useful in a crisis."

Before the crisis, macro definitely seemed to be moving toward huge, unwieldy models with tons of different "shocks" and a number of "frictions". And there still is quite a bit of that. But a lot of macro models that I've seen recently definitely seem to be more of the stripped-down, "let's tell a story about this one mechanism" kind of models. And I've even seen some macro people using simple OLG-type models instead of the infinitely forward-looking, "fully specified" monsters that usually go by the name of "DSGE". No, these aren't simple supply-and-demand curve diagrams. But even if it hasn't given Paul Krugman what he'd like, macro seems to be giving Ricardo Caballero a little more of what he wished for in 2010.

The real critic that matters in this case isn't the public; it's central banks and policy advisors. The public never has to use macro models, so of course it doesn't (or shouldn't) care how unwieldy they are. But central banks and policy advisors need models they can both understand and apply in a crisis situation. Whether or not macro's new crop of models will give them that is an open question, but hopefully we won't have to see it answered in the near future.

5. "Macro is too political."

When we read prominent economists writing in the WSJ denouncing fiscal stimulus, or calling for higher interest rates (for a different reason every week), it's hard not to think that macro is just a pack of conservative hyenas with the odd liberal honey badger thrown in the mix. But you have to realize that there's a heavy selection bias going on here - the macroeconomists who write in the press are going to be the people who are both A) the most interested in policy questions, B) the most confident in their policy-related beliefs, and C) the ones who attract the most attention from the readers of the WSJ or wherever. In terms of academic macro, the evidence says that it's only slightly aligned with the big Red-Blue divide of American politics.

Of course, academic politics is another matter. There are big divisions over things that practically no WSJ reader is going to care about - TFP shocks, sticky prices, parameter calibration, etc. "Freshwater" and "saltwater" still describe a real human network divide (even if the theoretical battles of the 1990s and early 2000s are fading now that financial macro has taken over). But academic politics is not the same thing as national politics.

So maybe macro didn't actually manage to fend off this particular criticism, but I think the criticism was never really very accurate in the first place.

So to sum up: Macro definitely does not look like a dying research program, stuck in scholastic navel-gazing while the world passes it by. I could name a couple research programs that do look like that, but macro is not one of them. Instead, it looks like a vigorous, energetic field full of excited young true believers and respected older figures who are still blazing new trails. Instead of retreating into the ivory tower and ignoring its weaknesses after 2008, macro has aggressively moved to put finance into its theories, while playing around with things like heterogeneity, learning, and simpler forms of models. Nor is the world losing interest in macro - it remains the single biggest, most glamorous, and most popular field of economics, and the biggest destination for top job market candidates.

Of course, that doesn't mean that macro is as awesome as its boosters would tell you. I think it has some big problems. But today I don't think I'll harp on those. Today, I think I'll just give the macro field its due for answering so many of its critics in quiet but decisive fashion.

104 comments:

" The representative-agent thing had actually been challenged long before the crisis."

So fucking what? Those models dominate in the profession - no matter how many qualms are expressed. It's as if astronomy were dominated by Keplerian models, justified as "an approximation" and some astronomers were critical but every intro text and 90% of the published papers accepted Kepler. Hey the mathematics is harder the other way.

Not for nothin', but they call it The Dismal Science for a reason. Let me translate into Commoner your third from last paragraph, a single-sentence piece of genius: Nobody knows what the hell they're talking about.

To heterogeneity in #3, until human emotions are accurately installed, the models will necessarily break down in crises. If you can do it, son, you might make this an actual science. Money makes people crazy. That's a natchul fact. Don't look at the bad borrowers; look at the people who put piles of money in front of them. Why and how does that happen? (Rational actors! I am teh lulz.)

To prediction in #1, lots (okay, a few) people I know in real estate were totally freaked out when we saw interest-only loans advertised on sports game TV. Granted, we're Gen X skeptics, mostly commies and distrust finance. That it took so long to blow up...that was the surprise.

But to #5, no portion of the finance cluster can be too political. The depoliticization of the economy represents the greatest risk to everybody and everything. Everybody who can vote, votes with their pocketbook, the old saw goes. The very idea that the economy is "above politics" is itself dangerously, evilly political.

You know that asshole Dylan Ratigan, used to be on CNBC? I call him a commie-come-lately. There's worse clubs you could join.

I'm still not convinced that no one predicted the crisis. It seems to me that I remember people predicting the crisis at the time and when you saw in 2005 how the subprime market looked it certainly seemed like we had a real estate bubble. The reason that Macro didn't predict it was that it was believed that you couldn't have a national real estate bubble, that you could maybe have a regional one but not at the national level.

Now it's true that there are people who are always predicting a crisis but this doesn't mean there wasn't good reason to predict one during the housing bubble. I at the time thought a crisis was very likely-and I have of course had no model-but I don't think we're going to have another one soon. I think what Macro guys ;like yourself have done to answer this charge is kind of change the question a bit. You don't think anyone can really make meaningful predictions or if anyone gets a prediction it's just luck anyway as you believe in; rational expectations.

As for the idea that there is nothing to replace rational expectations, the question begs: what did they have before this? There was a model before RE that wasn't unweildly or to clunky to use-adaptive expectations. I know that today many claim that AE assumed people were 'stupid' but I don't think that's true, it just didn't think people were omni-rational.

This isn't really a choice of a model between where people are rational or one where they're irrational. I think the real knock on RE is that it has a very special kind of rationality in mind. I don't think that those who criticize it think that people are just always irrational-though perhaps they are sometimes.

The sense in which RE means 'rational' is felt to be very extreme-that people basically are able to be wholly forward looking and incorporate every consideration before hand, always fully optimize, etc.

If you're with friends in your speedboat , pulling away from the dock , and a grizzled old salt who's watching tries to warn you that you're overloaded , would you pay any attention to him ?

I doubt that you would. The old salt wasn't working from a " hard model " , but rather from judgement based on experience and the rough empirics of your specific case - the size of your boat and hp of its motor , the amount of freeboard showing as you cruise by , your obvious inexperience , etc. So you go on cruising out of the harbor , and sure enough , later that day , you try to back into a following sea , a big wave comes over the transom , and you sink. Now you're feeling stupid , and rightfully so . Looking for a way to save face , you explain to your friends that since the old salt couldn't tell you just which wave , and when , would swamp your boat , he must have just made a lucky guess. And you have to keep telling your friends that , over and over , because you know that as time passes and they think about it more and more , they'll realize that the old salt was pretty smart , and then you'll have to find new friends to go boating with.

And Noah, it's not 'predict the crisis', in the sense of 'in the year XX, company YY will fail due to an increase in ZZ of item ZZZZZ'; although right-wing macro guys like to say that that's the critique.

Their failure (and this is shared across the macro spectrum) was that they deregulated the financial industry, when history documented very strongly its crisis-prone nature. If you destabilize the ship, one might not know the exact timing of the wave which capsizes it, but it is prone to capsizing.

And your comment about macro not having banking and the financial industry in it makes it worse; it's like destabilizing a ship when you have deliberately factored out key parts of the ship from your models.

And in addition, if macro did not have those factors in their model, this supports the idea that modern macro (main on the right) ignores data.Krugman was citing Tobin's work from the 1960's; where does one see that in the RBC literature from the 90's and (pre-Crash) 2000's?

"precious few people predicted the crisis, and a number of those that did have tended to be the type of people who predict crises every week."

I like Michael Pettis' reply: "What actually happened is that the former bulls immediately trotted out the stopped-clock analogy. The reason the worriers turned out to be right, they earnestly explained, is that they are perma-bears, and as everyone knows a stopped clock will always be right twice a day. This doesn’t mean, however, that models used by the worriers were right and the models used by the bulls were wrong, so of course there is not need for the bulls to change their models....superficiality of those analysts who don’t see why describing a growth model that is generating an unsustainable increase in debt is not the same thing as predicting a collapse in six months. ...This strikes me as an incredibly superficial analysis, explained only by the fact that many of us expect economic analysis merely to predict whether the stock market will rise or fall this week....Those who worried about rising consumer credit in the US were not wrong every single year until 2007-8, when they accidentally became right. They were right every single year, and were proven right in 2007. ...Whenever a bull defends himself with the stopped-clock analogy, it suggests to me that he is likely to be an economic illiterate – and completely wrong to boot. "

Similarly, the Iraq War supporters have now for the most part convinced themselves that they were just unlucky, not wrong, and that the war opponents were just deranged Bush haters who were not actually right anyways.

IMO, Pettis is far and away the best source on these issues. The broken clock quote is great.

I love Noah's site as well. It is well regarded (and deservedly so) for its analysis, but I must admit the defenses listed above seem more like bob-and-weave than well-considered arguments.

"First of all, precious few people predicted the crisis" and "I don't think many people inside or outside of the profession thought in 2007 that macro was able to predict recessions, financial crises, etc." The first is just silly. Most non-physicists can't explain quantum mechanics (of course, most physicists have trouble with that as well). And the second avoids the whole point, doesn't it? Isn't the point that if you can't predict (at least parts of) the business cycle, then don't you have to find a way to justify all the resources going into the study of macro? This isn't literature or navel gazing. Aren't we trying to figure out how things work so that we can make them better? How else to do that other than by finding ways to anticipate catastrophes? I get the earthquake analogy, but there are a lot more resources going into macro than seismology.

Further, doesn't point #2 (about finance) completely undermine point #1? Isn't that the crux of the criticism that finance wasn't a part of the models? I mean, it's great that now it's being incorporated, but if we're going to start a blame game (and we don't have to), I think it's a good place to start by asking why in the world finance wasn't incorporated in these models in the first place. [And seriously, there were many people who made this criticism and were ignored--not that those people were right on everything, but they should get credit for what they did get correct.]

I get that this is specifically designated as a sort of apologia, and that Noah says criticisms will be for another day, but even on that basis (and I'm not a big macro critic), I find these defenses well short of compelling.

"In 2011, a lot of the people who supposedly got 2008 were predicting another crisis - a wave of government defaults, followed by hyperinflation. Didn't happen."

I think what happened in 2011 was the US was looking like going to fall into another recession, so QE2 was launched. Chinese government was also beginning to de-leverage, its real estate market was beginning to fall, but decided to reopen the credit spiogot because of the 2012 leadership transition.

because instead of mastering the field and really understanding it, all the trainees have to "come up with something new"

I don't think you should be allowed to come up with something new until you master that which is there , but I don't think trainees are even required to read let alone master the general theory by keynes for example

Kinda my point. As you noted, macro is a major area in the econ profession in terms of employment of economists and research output. String theory is not for physics. Macro has not produced a useful engineering to forecast and/or prevent economic catastrophes. On the other hand, a lot of physics is very useful for underpinning a vast, useful engineering. And I thought string theory was starting to be considered a dead end by the profession as demonstrated by the lack of hiring of theoretical physicists. Is that right?

Forgive me for my ignorance, but how much of applied physics and engineering is based on string theory? I believe that no matter how many good minds it sucks in, we are not basing public policy on string theory.

Ugo Panizza gave me this reference from War and Peace. Here, Tolstoy is describing General Pfuel.

"The German's self-assurance is worst of all, stronger and more repulsive than any other, because he imagines that he knows the truth- science- which he himself has invented but which is for him the absolute truth.

Pfuel was evidently of that sort. He had a science- the theory of oblique movements deduced by him from the history of Frederick the Great's wars, and all he came across in the history of more recent warfare seemed to him absurd and barbarous- monstrous collisions in which so many blunders were committed by both sides that these wars could not be called wars, they did not accord with the theory, and therefore could not serve as material for science.

In 1806 Pfuel had been one of those responsible, for the plan of campaign that ended in Jena and Auerstadt, but he did not see the least proof of the fallibility of his theory in the disasters of that war. On the contrary, the deviations made from his theory were, in his opinion, the sole cause of the whole disaster, and with characteristically gleeful sarcasm he would remark, "There, I said the whole affair would go to the devil!" Pfuel was one of those theoreticians who so love their theory that they lose sight of the theory's object- its practical application. His love of theory made him hate everything practical, and he would not listen to it. He was even pleased by failures, for failures resulting from deviations in practice from the theory only proved to him the accuracy of his theory."

100 years before Ender’s Game, the chineese aliens arrived on U.s of A with fire and death. This is the story of the First Formic War.,,,Formica rufus war's

Victor Delgado beat the alien ship to Earth, but just barely; not soon enough to convince skeptical governments that there was a threat. They didn’t believe that until space stations and ships went up in sudden flame.

And when that happened, only Mazer Rackham and the Mobile Operations Police (MOPs) could move fast enough to meet the threat."

Publishers Weekly review:

"Scott and Johnston explore human ignorance and compassion through a tapestry of galactic warfare in the second volume of the Formic Wars trilogy, collectively a prequel to Ender’s Game. After the independent asteroid mining ship El Cavador is attacked, Victor Delgado escapes and joins State Official Imala in warning mining magnate Ukko Jukes and Earth’s scientists of approaching hostile insectlike aliens called Formics. While diplomats seek a peaceful solution, Rena, a matriarch from El Cavador, gathers her surviving people aboard a scavenger ship, and damnable villain Lem Jukes, Ukko’s son, plans to overtake the Formic ships and defy his father’s iron grip. Against this operatic backdrop, heroic Lt. Mazer Rackham and his special forces stand alone against the deadly insectoids. Card and Johnston craft cinematically detailed environments for their space miners, thieves, and outcasts, probing the inner mechanics and conflicts of various groups. Social upheavals and political ineptitude are realized through rich characterization and brisk action, marrying the genre staple of alien invasion with conflicts of conscience."

The Formic ship starts by destroying Kleopatra and a fleet of over 60 assorted ships near it. It launches three landing craft in southeast China, and the Formics use gas to defoliate the area and kill everyone. They create mountains of dead biomass near their landers.

Before the landing, Mazer Rackham has been training the Chinese military on a new aircraft, the HERC, in exchange for training on their new devices, the drill sledges, craft that can tunnel underground. During the Formic invasion, he saves Bingwen from them, but is then shot down. Bingwen uses a Medi-Assist device, voiced and then controlled by Mazer's romantic interest, Kim, to save his life, and the two set off to destroy the nearest Formic lander.

The MOPs head in as the Formics commence their invasion, and discover a new, efficient way to kill Formics by destroying their transport craft on the ground. They also head to the lander, where they save Bingwen and Mazer from a Formic attack. The lander has heavy shielding, but it doesn't extend underground. Mazer manages to find some drill sledges and HERCs for them, and they use the HERCs to bring the drill sledges into range of the lander, while Wit gets a tactical nuke to hit the lander with. They successfully attack the lander, destroying it, but one of the MOPs, Calinga, is killed in the process. Captain Shenzu then arrives, placing Mazer under arrest.

Victor and Imala, meanwhile, have just landed Victor on the surface of the Formic ship, using a disguised ship provided by Lem. Victor goes into the Formic ship through a gun port.

quote Stephen Fry: 'It is a cliche that most cliches are true, but then like most cliches, that cliche is untrue.', TerrQuotes About Clichés 69 quotes have been tagged as clichés: Bette Davis: 'When a man gives his opinion, he's a man. When a woman gives her opinion, she's a bitch...

If you can't predict a monster crisis that swamps everything useful that has been done with macro policy over the last 3 decades, then you have a serious uphill battle here. The research program will continue for the same reason farm subsidies continue, powerful entrenched interests.

i think the paralysis of macro works very well for people with money in general and the financial industry in particular. I see little reason for questioning that big doses of stimulus would increase demand and employment. I also see little reason for questioning that the financial sector has grown to be parasitic on the rest of the economy. However by creating large doses of confusion, the profession helps to promote inaction that sustains incredibly destructive policies.

If you're asking where the money comes from, much comes from these sources. For example, Martin Feldstein got several million from AIG (on whose board he sat) for NBER. There is no shortage of rich people who quite openly contribute to universities and foundations. And of course the banks largely control the Fed and its research agenda.

I don't see many mysteries here.If all the money flowing to support macro research were instead coming from union and union leaders do you think it would look the same?

".If all the money flowing to support macro research were instead coming from union and union leaders do you think it would look the same?"

One of the many ideological kinks of Mainstream Economics is that we are supposed to believe that, unlike nearly everyone else, Economists are motivated by a desire for truth, and are not "optimizers". The other exception to the rule is for corporate Managers who are motivated by the interests of the Firm, not their personal interests - a theory Adam Smith would have found hilarious.

But a ton of the current "financial macro" stuff is not good news for the financial industry. Macro people may not have predicted that finance would cause a crisis, but they seem pretty eager to accept that it did.

I don't think most money for macro research comes from investment banks. I think it comes from the Fed system and from universities themselves. Financial econ is, of course, a different story.

I'm not saying all the research supports the moneyed interests. There is not open censorship, if there were, macro would lose its usefulness. Instead we have serious affirmative action for all sorts of nonsense that obscure what should be obvious -- and yes, seeing the crisis should have been obvious.

I find it hard to believe that the support of moneyed interests for conservative derp-heads prevented macro as a whole from anticipating the crisis.

Since you're literally the only person I know who confidently and correctly predicted the crisis (including many of the specifics of the crisis) well ahead of time, while avoiding making other crisis predictions that didn't pan out, I find it uniquely hard to argue against your assertion that the crisis should have been obvious.

Noah - you need to think more about how peer-review breaks down. Many of the criticisms you cite as answered all boil down to the same thing in practicality. There's a stranglehold on the big journals by particular schools of thought and nothing that doesn't fit gets published. Those schools of thought tend to be funded by outside interests.

Economics is uniquely vulnerable in this way because it take a scientific view of peer review - "data will shift the paradigms" - but in reality we just haven't solidified (and some would argue that since it's a complex human system, we can't) the theory of the discipline enough to use data in this way. Natural experiments are better than nothing, but even those invariable are filled with external influences. So data never overturns the paradigm and the interests can keep their lock hold of the journals.

Noah, you seem a bit willfully blind here, because in fact a damned goodly number of people -- all economists in the holistic sense -- largely and confidently predicted the crisis, not least in the shorting industry, where a minority made an absolute KILLING. (And you like to mark to market that way, so you should note this.)

So the question is, and I think something like this is what Dean Baker is saying, is that macro is a toolset, but the tools are used in a sociopolitical context, and that context is what drives the distribution of prediction and opinion. Clearly, macro as a whole did not anticipate the crisis, but the fact that some people using macro toolsets did indicates that the cause of the misdistribution lies elsewhere, yes?

" First of all, precious few people predicted the crisis, and a number of those that did have tended to be the type of people who predict crises every week."

This is a startling piece of inanity in an otherwise good post. (Actually, I like your blog, find it educational, and feel guilty that I only seem to comment when I have a gripe.)

The point is the financial system was (is?) characterized by extreme leverage, high interdependence, and complex, opaque financial instruments with a notional value orders of magnitude greater than anything in the real economy. The inability to see that this system was failure-prone and liable to take the real economy with it when it went down was an enormous case of theory and ideology induced blindness.

The failure to regulate it seems to have been based on the shibboleth that "the market" must be right about how to arrange this stuff. When Raghuram Rajan pointed out some of what should have been obvious Larry Summers called him a Luddite. No GENERAL but LUDD means the POOR any GOOD.

Of course, another motive for the failure to regulate came from the fact that wealthy, influential people were profiting enormously from that failure. But it's the responsibility of economics to criticize this, not to justify it.

The blame for the failure to predict the crisis is exacerbated, not excused, by the fact that so many who should have seen this did not.

People are finally paying attention to the influence of the financial sector, and that's a very good thing. I wish they hadn't needed to have it shoved down their throats first, but I'll take what I can get.

So, there is heterogeneity in macroeconomic models. Yes. But I always wonder why so few people point out that this heterogeneity is extremely limited. Agent-based models with agents who actually interact with each other ("for real", not just so as to make general equilibrium conditions fit) would be a big step forward I think. Claiming over and over again that macro incorporates heterogeneity, suggesting that it does so in a sufficient way, doesn't make it true.

Aside from being marginalized, the problem is that they share the same assumption that there are no social generators of economic behavior. The preferences of agents in the US economy for .e.g gasoline powered vehicles is predicated on massive state investment in roads and petro production, military protection of persian gulf, tort laws that protect producers, eminent domain ... But this is all outside of Economics Flatland.

But Noah, if you cannot build mathematical models that even approximate the functioning of actual systems, then you should not build mathematical models at all. Mere desire to have a mathematical theory plus mastery of some mathematical tools that may or may not be the right ones for the task does not imply that the correct type of scholarship is to build models.

Actually, if it doesn't work, it still can have a negative effect. The dominance of libertarian policy proposals in part comes from a vast body of economics in which the role of the state and public works is purely as cost - supposedly because the math is too hard otherwise.

There is good work being done in experimental econ that uses statistics. and maybe you can actually build useful models of bigger systems, but the it's wrong to build clearly false models that encode a harmful view of people and society just because you can't think of how to do better.

"The dominance of libertarian policy proposals in part comes from a vast body of economics in which the role of the state and public works is purely as cost - supposedly because the math is too hard otherwise"

Just a minor nitpick - the kind of learning George Evans writes about is not really Bayesian. In those models, agents form expectations by running regressions on past data, and then computing point forecasts, pretending as if estimated parameters were fixed. So it's more like frequentist learning, I guess.

Behavioral economists often argue that economists should incorporate more insights from psychology when modeling human decision making. These insights usually involve patterns of irrationality. In fact, some of the most interesting work in cognitive science these days involves modeling human reasoning and learning as approximate Bayesian updating (see http://cocosci.berkeley.edu/tom/papers/bayeschapter.pdf for a good overview). Perhaps we can agree that rationality in economics is a poor theory of human decision making, but the alternatives (heuristics and biases, or Evans-style regression learning) are not obviously better. There's a big arbitrage opportunity awaiting young economists who reinvent traditional models using approximately Bayesian agents to leverage findings from psychology while preserving much of the intuition of conventional economics.

A lot of the stuff that came out of the last four decades did not help us deal with it either. Long term government bond purchases as a means of dealing with a liquidity trap? We got that far almost over three quarters of a century ago. If we are not properly informing and coming up with new ideas for governments and central banks to deal with unemployment and poverty which affects most of the world:s population, what are we doing? A lot of learning from old historical mistakes was forgotten, including the causes of financial crisis, and this stuff still remains un-relearned. It looks very much like business as usual for me. There are not enough alternative lines of enquiry to the DSGE based stuff, even though its micro-foundations are very questionable. Ask central banker with real responsibility, is DSGE helpful? How many more decades of this stuff do we need? Most social sciences have several competing theories which serve as alternative reference points, especially if the theory is as precarious and politically controversial as some of its fundamental underlying assumptions. Also not enough attention paid to what developments have taken place in other subjects, most importantly, the other social sciences which can tell us how people and societies behave - important for understanding the behaviour of macro-variables in different places at different times. This stuff is still on the fringe of macro if it is anywhere at all. Why? I think because it does not fit in well with abstraction and formalisation, which oddly are considered goals in themselves in macro, rather than means to an end.

In sum macro is still trying to integrate everything into a single very questionable methodology. As long as it does that it is useless at best, potentially socially damaging at its worst.

So not one mention of growth theory? Has macro moved to seriously understand the evolution of inequality in capitalistic systems? No. All those assertions by Solow and Kuznets about "balanced growth paths" were complete nonsense. They had no empirical basis on which to make such claims. If anything, capitalistic systems tend toward ever increasing levels of inequality until a political revolution occurs undoing the extreme inequality, as Thomas Piketty has routinely pointed out. Your defending a paradigm that is completely and utterly ignorant of these facts.

I agree that blanket demonization of macro goes much too far, but some of your defenses, Noah, just don’t wash.

“....there are things out there that are just really hard to predict, like earthquakes.” This really misunderstands what seismologists do. Yes, it would be useful if they could say “we predict a magnitude 7.9 quake centered under the Seattle Space Needle at 9:45am next Thursday.” People would avoid the Space Needle that morning, and if the prediction is right a lot of lives could be saved. But that’s not the point of seismology. Rather, we now know there are fault lines and that the earthquakes they generate are different based on the specific plate structures associated with them. We understand earthquakes pretty well, even if we aren’t much closer to predicting when they will occur. This has practical significance for land use, building codes and lots of other stuff. Macroeconomics should be judged by the same standards.

“....macroeconomists are definitely thinking about heterogeneity.” Come on, you must surely see that one can have both heterogeneity and representative agents. If there are 300 million agents in an economy and you model them as two or three decision-makers, on balance you are doing a lot more homogenizing than heterogenizing. This matters because just about everything we know about complex systems tells us that the density of interaction effects is central. An economy of you, me and a few other people simply isn’t going to have the same dynamics as an economy of millions of interacting agents. This is true even if agent-based modeling turns out to be unproductive. It’s enough to know that the model people are using is systematically giving bad advice. Microfounding macro is a choice, and if the there aren’t any good microfoundations at hand, you don’t have to do it.

Repeat after me: Realism is not the objective, understanding an otherwise complex world is. What is it that you learn if you have 30 degrees of heterogeneity than 3? What about 300? Is the increased complexity worth it? This is the right question to ask.

So what are you proposing? To have 300 million different agents? Different in how many dimensions (risk aversion, patience, age, cognitive skills,...)? Good luck with that! Or, since we cannot model 300 million people different in many more than one ways than one, should we give all of them up and study aggregate relationships without reference to human behavior?

“....there’s no clear alternative [to rational expectations].” The previous paragraph applies here as well. If the only microfoundations you can find are empirically disconfirmed, regularly and broadly, then you may just have to postpone this microfounding business until you can come up with better models. Beyond that, I think the core problem is that the models are structured to permit the solution of equilibrium conditions, and that this imposes a restrictive framework for thinking about rationality, optimization. If the point were to model adjustment, we could use a much looser but more empirically defensible conception of rationality. Of course, that would also mean severing economic analysis from welfarism: we’d have to give up trying to answer questions like“what’s the welfare cost of this situation compared to the optimum?” In the end, the attachment of economists, micro and macro alike, to equilibrium models with rational agents is that they want to be able make definitive judgments about what society should do. I prefer Keynes’ dentists: they don’t tell you whether you have an optimal dental structure, but they can help you get the structure you tell them you want.

If rational expectations are based on Expected Utility (as it is....) then rational expectations has been refuted a hundred-fold. There is a vast literature on this (c.f. Allais paradox, Ellsberg Paradox etc.). Finding rational expectations in "simple situations" is a useless test of rational expectations. It is too easy a test to pass. Being a bit of a Popperian I would argue that one should test Rational Expectations *severely*- in complex situations. (I would, incidentally say the same for some "market experiments" that find market equilibrium in a situation where it is virtually impossible to avoid).

Rational expectations =/= expected utility. If you're going to speak in public, then you should at least be aware of work that is nearly 40 years old at this point. So many stupid people visit this site, but I suppose it isn't surprising given the stupidity of the producer.

“....[macro] looks like a vigorous, energetic field full of excited young true believers and respected older figures who are still blazing new trails.” The more accurate criticism of macro is not that it is simply an ideological smokescreen or an unthinking herd, but that it operates on a tilted playing field. It is openly acknowledged that the “leading” (i.e. career-determining) journals have engaged in tendentious selection practices for the past generation. Lots of shoddy research (which in my book includes calibration exercises promoted as “testing” theories) has gotten the star treatment, alongside a stream of genuinely significant macro work. Ideologically loaded assumptions, such as those typically used in public choice, are dropped in without any justification. Not all macro is bad! But the problem is that (a) the bad stuff of a certain ideological orientation gets an extra push that the good stuff doesn’t get, and (b) there isn’t a clear process by which the bad stuff is weeded out over time as its badness becomes evident. We refight the same damned macro battles year after year.

In principle I applaud you for writing this post. However, I also disagree with it.I will make counter arguments1) Mainstream macro models implied that the crisis was impossible (and therefore nothing like that happened in the 30s or in Indonesia, or Argentina). Known unknowns are different than known unknowns. For example, noted ultra orthodox new Keynesian OJ Blanchard now says the target inflation rate should be 4% so real rates can be cut to -4% if necessary.

2. On finance see your post on fighting the last war. Bernanke and Gertler are not obscure figures, but their work was ignored until it was too late.

3a) Economic theory generally is elastic. In response to the criticism that a representative consumer is assumed, models with heterogeneity are presented. When the criticism is not made, models with a representative agent are used because they might be useful approximation. This methodology makes theory completely invulnerable to data.

b) rational expectations. See 1. The statement that people are irrational but we can't understand all the ways they are irrational can be useful. Sincerely admitting that we can only model using rational expectations but that our models are therefore unreliable implies that we can't be sure that, oh say, the US won't fall into a liquidity trap and so the costs of 4% inflation are tiny compared to the benefits of the option to cut real interest rates to -4%. The problem isn't that economists can't complete psychology then use it to make economic hypothesis which might be true. The problem is that economists insist on making predictions with confidence intervals which correspond to gross over confidence in models.

Also there was macro before the rational expectations revolution. A defence of 2014 macro must begin with the assertion that it works better than 1973 macro. This is not argued. It is considered too obvious to need arguing. I assert it is also inarguable as 1973 macro is demonstrably superior in many ways (definitely in every way I have examined).

4) see 2, 3, and your post on fighting the last war. This has all happened before. There are macro models used to clarify ideas which I simple enough to be clear and which are discussed when macro falls on its face again. Macro models in the early 80s were elegant. They were also grossly inconsistent with the data. They were developed to deal with the failure of the old huge clunky paleo Keynesians to fit the data at all.

Then one fiddle factor was added per moment matched and they became huge and clunky too. The current models are not clunky and don't fit the data at all. They are in the developing ideas stage. They will be huger and clunkier than the pre 2008 models.

Macro models can be elegant and motivate intuition. Or they can fit a lot of data (with a lot of free parameters). They can even fit the last crisis which the older models implied was impossible. But there is no sign that macro is leading to anything useful.

'But you have to realize that there's a heavy selection bias going on here - the macroeconomists who write in the press are going to be the people who are both A) the most interested in policy questions, B) the most confident in their policy-related beliefs, and C) the ones who attract the most attention from the readers of the WSJ or wherever."

This diagnosis remarkably parallels the one made after extensive data analysis by Philip Tetlock in "Expert Political Judgment: How Good Is It? How Can We Know?" This excellent book is considered canonical in some circles; so, I'm putting in a plug for it here.

It is difficult for economists to imagine reasoning without mathematical models. I guess because most grad students are originally from the sciences. Mathematical models are only helpful to generate applied models for forecasting. Even then, people who make the decisions don't use them. We are going to have to learn to live with subjectivity. This is the only way we are going to get real understanding. We are after all dealing with humanity. Being able to deal with subjectivity and things being true and false at the same time is a type of intelligence.

There is a historical reason for this. The prevalent neoclassical school insisted in trying to be like a 'hard' science by adopting a formal mathematical framework. Thus confusing mathematical rigor for scientific robustness. In the process, they took many shortcuts that make the foundation of the theory inconsistent.

It is a common misunderstanding that the only legitimate sciences are those that adopt a formally rigorous mathematical framework. Much of modern nonlinear complexity science only relies on computer experimentation because there is no formal math that can provide satisfactory solutions, and yet it is one of the more productive areas of scientific research.

In fact, to answer another of Noah's points, there are several alternative economic theories out there that have been marginalized by the academic cartel, which is dominated by the neoclassical gang. While no theory is arguably complete yet, some of the alternative theories would have helped a great deal understand the roots of the economic crisis. E.g. the works of the austrian school, Hyman Minsky and others.

It is difficult for economists to imagine reasoning without mathematical models. I guess because most grad students are originally from the sciences.

Actually most econ grad students were undergrad econ or econ/math majors, not science majors. And actually I think you're wrong that they find it hard to reason without math. Most of them either A) reason by logic and then express their thinking in math terms after the fact, or B) don't really reason very much at all, and just grind through the math (or, nowadays, the computer simulation) without contemplating what's going on.

We are going to have to learn to live with subjectivity. This is the only way we are going to get real understanding.

What do you mean by "subjectivity", and what do you mean by "real understanding"?

What do you mean by "subjectivity", and what do you mean by "real understanding"?

Epistemology and Ontology (Part 1).These areas have revolutionised other social sciences. Take a political scientist or a 101 student of international relations or anthropology and they would know what these terms mean. They are important for demolishing intellectual hegemonies. What you have written would be unacceptable in many other disciplines, even if it might be considered very astute to an economist. Intellectual hegemonies are dangerous, because of the reasons commentators above have identified: they marginalise other viewpoints and lines of enquiry, ultimately stifling creativity and innovation and consolidate existing power arrangements. Your definition of “irrational” reflects by association a view of “rational” which has come to monopolise the meaning of the word. The dominance of DSGE and classical micro-foundations in economics is arguably an example of such an intellectual hegemony. You dismantle these hegemonies by asking questions.How do these intellectual hegemonies arise? One explanation links it to international capitalism: “The bourgeoisie has through its exploitation of the world market given a cosmopolitan character to production and consumption in every country. To the great chagrin of Reactionists, it has drawn from under the feet of industry the national ground on which it stood. All old-established national industries have been destroyed or are daily being destroyed. They are dislodged by new industries, whose introduction becomes a life and death question for all civilised nations, by industries that no longer work up indigenous raw material, but raw material drawn from the remotest zones; industries whose products are consumed, not only at home, but in every quarter of the globe. In place of the old wants, satisfied by the production of the country, we find new wants, requiring for their satisfaction the products of distant lands and climes. In place of the old local and national seclusion and self-sufficiency, we have intercourse in every direction, universal inter-dependence of nations. And as in material, so also in intellectual production. The intellectual creations of individual nations become common property. National one-sidedness and narrow-mindedness become more and more impossible, and from the numerous national and local literatures, there arises a world literature (Karl Marx 1872).There are other explanations. A Realist explanation, which is probably a political science theory probably most closely linked with the dominant paradigm associated with rational choice theory in economics, would explain the world wide use of DSGE, for example, as basically the good weeding out the bad. But anyway the important thing is the questions. Then we can get real critical reasoning and understanding. We can, however, do without mathematical formalisation (another word that has been appropriated – would you call the General Theory or Plato’s Republic informal?) – if the goalposts are set to a gospel of contestable and political foundations. How did key concepts become to imply what they do and by association have implications for what they are not. Are they marginalising non-DSGE based forms of enquiry?

John Maynard Keynes would also not have approved his ideas being subsumed into general equilibrium theory, particularly insofar that it would have to conform with classical micro-foundations:

"Perhaps the reader feels that this general, philosophical disquisition on the behaviour of mankind is somewhat remote from the economic theory under discussion. But I think not. Though this is how we behave in the market place, the theory we devise in the study of how we behave in the market place should not itself submit to market-place idols. I accuse the classical economic theory of being itself one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future" (Keynes, QJE 1937, p 215).

Classical Economics arose in a certain place and time for a reason. It arose in Britain as the first country to industrialise. Its new middle class needed soft power (check precise meaning) in addition to gunboat diplomacy to subsume foreign markets (hence comparative advantage theory) and challenge existing power arrangements and the distribution of resources (hence market efficiency theory) until then monopolised by the aristocracy. The US also had to win a battle of ideas during the Cold War. These are some of the possible explanations for why we get certain hegemonies, by beginning to understand these things we can properly understand why we do things the way we do, why things have come to mean what they mean. By being open to such questioning the discipline will be on a sounder footing.

There is a major flaw in argument n.1 (and in others, but I focus on n.1).

The critique is not really that “macro did not predict the crisis”. The real problem is that modern macro says these crises cannot occur because the economy is in equilibrium, and therefore it denies their existence. It is not enough to point to the fact that other people did not predict the crisis. In fact, if we adopt alternative theories that the economy behaves like a “nonlinear complex system”, then a crisis will never be “predictable” in the traditional sense. However, if you have a theory that admits the possibility of a crisis, at a minimum people can stay alert and be prepared. Instead, because of the believers of the DSGE model, most people were caught with their pants down.

Other than that, most economists are really glorified salespeople, preaching the economic outlook that favors the selling of the products of the institution that employs them. You will never hear the chief economist of a big passive mutual funds company say that one should stay in cash for some time. Somehow the market is always expected to go up. Lol.

Yep. This critique hasn't been answered. This is closely related to the question of why finance-macro models were largely ignored and marginalized before the crisis, and whether macro "fights the last war"...

That's a good paper. I've actually read about 10 or 12 papers that test the REH, and only 3 or 4, I think, find support for it. The problem, as far as I'm concerned, is that the experimental studies we have generally find support for the REH:

I think RE is wrong most of the time, but I think it's right when the information environment is very simple and the stochastic processes involved are time-invariant. I think that's why experiments tend to support RE while empirical studies tend to rule against it. So this is something that basically has to be addressed with better experiments, and I hope one that I'm planning will contribute in that regard. :-)

Noah - not predicting the crisis is a bit odd here. The exact timing of the crisis was always difficult to forsee, but that one was coming was easy to see (just look at total endebtedness compared to realistic expected growth - particularly in median incomes). But models were not even pointing at potential fragility (perhaps because they are not actually built to measure risk - despite calling themselves "stochastic").

P.S. After reading Dean and others (including the economics team at Morgan Stanley, where I was working at the time), I sent an email around to friends warning them that a crash was coming (this I think was in 2006 or 2007). Dean was not alone in seeing the problems (the most obvious of which was the massive sustained US trade deficit and the massive increase in household sector debt).

What was impressive, was that the warnings were coming from both conservatives and progressives.

I don't think the trade deficit made a crash more likely. Japan had a trade surplus in the 80s but crashed all the same. We had a trade deficit in the 80s and 90s but our crashes were minor during that time. And after the 2008 crisis, the dollar rose rather than fell; very different than the standard narrative of a country with a trade deficit that experiences a sudden capital outflow.

Noah - the European countries worst affected by the crisis are all deficit countries. Look Noah - I agree Japan is an exception - but remember that before the financial crash Tokyo had the most expensive land in the world. The thing is that a deficit means (in general) that wealth is flowing out of the country, and depending how that is distributed that probably means that debt/income ratios are increasing substantially somewhere. And that means that there is a potential sustainability issue.

When I was reading about the approaching storm, the people who were worried were looking at balance sheets, the people who weren't were looking just at flow statistics. It is like draining a dam - eventually it will be empty (saying when is difficult because the flows into the dam are stochastic). Sure it is possible for the flows to reverse and everything to be dandy - but there was no obvious way for that to happen.

Noah - also (as I just noticed) the fact that the USD increased after the crisis is a result of the problem that caused the problem. The US is not vulnerable to hot money flows because all its debts are in its own currency (it is countries that borrow in foreign currencies that are deep water if the currency devalues). The problem is that the trade deficit was both huge and persistant, and the currency markets were not responding appropriately (i.e. making US exports cheaper and imports more expensive). In Europe the EUR had the same effect and creating and sustaining huge balance of trade imbalances.

I admit Japan is different (and I wish I understand why). The trade surplus means that money was flowing into Japan - which should have pushed up the Yen and reversed the trade surplus. Instead the surplus remained and all that extra purchasing power went into a mega land bubble instead of imports (as it would in almost any other country). Noah it is Japan that is different, rather than the example.

An interesting piece as always, but one inevitably that would spark off disagreement.

I think this comment:

"Nor is the world losing interest in macro - it remains the single biggest, most glamorous, and most popular field of economics, and the biggest destination for top job market candidates."

I wonder whether that is a good thing. If it is a way into Goldman Sachs it probably isn't a good gage of its social value. If it is because people feel that it is contributing to our knowledge about how to reduce poverty and unemployment, sure.

I truly believe that dsge models will eventually be replaced by agent-based computational models. As computation becomes exponentially cheaper it becomes easier and easier to model the real world without the assumptions required of any general equilibrium model. Genetic algorithms (or alternatives) allow agent preferences to update in a more realistic way. Emergent phenomena caused by non-rational thinking can be better examined to discern macro fluctuations.

One of the more interesting lines of study in ACE is the idea of norms and how culture affects rational expectations. The basis is that people have limited ability to ascertain optimal reactions so as to update expectations. Instead, they use societal norms as a simple heuristic and save the necessary brain power by adopting the strategies of others who have already confronted the situation.

Many assumptions in macro models have held up OK in some ACE models. Things like the permanent income hypothesis is a fairly good rule of thumb in many situations with the caveat that it works better if the agents have a variable time horizon over which they optimize.

As a younger more computer savvy generation takes over Macro I think we will see economic forecasts more akin to weather forecasts.

Of course, true long term forecasts will be beyond the ability of any amount of computation nor will the theories developed necessarily be elegant or easy to communicate to a lay audience.

You might believe it, but it isn't going to happen (oooh, violation of rational expectations!); what is going to happen if that search models with individualized transactions will be integrated into the models (Lagos-Wright or Burdett-Judd). That isn't ABM, which is fundamentally about stupid agents doing stupid things.

I can see why you spend your time posting on Noah's sad little website -- you aren't capable of doing anything useful.

Noah: "This one never really seemed to stick in the first place. First of all, precious few people predicted the crisis, and a number of those that did have tended to be the type of people who predict crises every week. In 2011, a lot of the people who supposedly got 2008 were predicting another crisis - a wave of government defaults, followed by hyperinflation. Didn't happen. Meanwhile, people remembered that there are things out there that are just really hard to predict, like earthquakes.

And also, it's not like macroeconomics betrayed the people's confidence in this regard. I don't think many people inside or outside of the profession thought in 2007 that macro was able to predict recessions, financial crises, etc."

The charge is that their 'reforms' destabilized the financial system, in ways well known from history. That charge is true. Predicting the exact *date* on which a major crisis started was the issue.